The Importance of Battlefield Nuclear Weapons

I’ve been writing a lot about the game of chickenrecently, most often in connection with the GM and Chrysler bailouts. On the Chrysler front, the game is in its last hours. Even after a consortium of large banks agreed to the proposed debt-for-equity swap, some smaller hedge funds are holding out for more money, and even the extra $250 million that Treasury agreed to kick in seems unlikely to keep Chrysler out of bankruptcy.

The problem is that bankruptcy is the only weapon Chrysler and Treasury have in this fight, and it’s a strategic nuclear weapon. Bankruptcy is the only threat that can get the bondholders to agree to a swap; but because a bankruptcy carries some risk of destroying Chrysler (because control will lie in the hands of a bankruptcy judge – not Chrysler, Treasury, the UAW, or Fiat), and taking hundreds of thousands of jobs with it, everyone knows that Treasury would prefer not to use it. The bondholders are betting that they can use Treasury’s fear of a bankruptcy to extract better terms at the last minute. (And it’s even possible that the large banks agreed to the swap knowing they could count on the smaller, less politically exposed hedge funds to veto it.) But Treasury may still press the button, because it needs to make a statement in advance of the bigger GM confrontation scheduled for a month from now.

But there’s a much bigger, slower game going on at the same time, and the administration’s basic problem is the same: all it has is strategic nuclear weapons that it absolutely does not want to use. The New York Times had an article today about how “a growing number of banks are resisting the Obama administration’s proposals for fixing the financial system.” It didn’t have a lot of new information, but it summarized the outlines of the game.

The administration has created three main tools to help the banks – and it really, genuinely wants to help them:

The Term Asset-Backed Securities Loan Facility (TALF) to provide funding to the asset-backed securities market, which is being expanded to mortgage-backed securities.

According to the Times article, the banks want none of it – even though, as many people (including us) have argued, the terms of these programs are clearly favorable to the banks.

Instead, banks such as Bank of America and Citigroup are arguing that they are more sound than the stress tests indicate. This claim is almost not worth debunking, but I’ll give it a few words anyway. First, the “more adverse” macroeconomic scenario used in the stress tests is already more optimistic than the forecasts of respected bodies, such as the OECD. Second, the IMF recently estimated total losses on financial institution balance sheets at $4.1 trillion, future writedowns by U.S. banks at $550 billion, and U.S. bank capital needs at $275-500 billion. If B of A and Citi don’t need the capital, who does?

In addition, according to the Times, “Several big banks have declared they have no intention of participating in the [PPIP]. . . . Many banks are reluctant to sell their nonperforming loans because they could suffer big losses, forcing them to raise more capital.” Finally, only $6.4 billion in loans have been given out under the TALF – a program currently sized at $200 billion, and projected to grow to $1 trillion.

Why are the banks turning their banks on this government largesse? I think there are two reasons.

First, taking capital under the CAP or selling assets into the PPIP involves some hardship, despite the taxpayer subsidies involved. Raising capital dilutes existing shareholders, and selling assets (at prices where someone will buy them) will require writedowns from their current, unrealistic book values. Treasury really wants the banks to participate, because it will increase confidence in the banks, and that’s why Treasury is offering to share the pain, via underpriced capital and low-risk loans.

But even though Treasury is so generously offering to share the pain, what’s the incentive for the banks to suffer any pain at all? We know the government won’t use the strategic nuclear weapon and let them go bankrupt or pull their banking licenses (which amount to the same thing). And Tim Geithner’s request for a battlefield nuclear weapon – resolution authority for systemically important financial institutions, including bank holding companies – seems to be going nowhere in Congress. This is not surprising, since the banks have already demonstrated that they can count on most or all Republicans and at least a few Democrats in the Senate. With the administration’s hands tied and the banks’ political power intact, the banks are in the same position they always were: if things go well, they will make money; if things go badly, the government will always bail them out later, on terms they are willing to accept.

On the one hand, the banks are complaining about unprecedented government interference and pressure, and to some extent that is happening. But on the other hand, the banks are ultimately calling the shots, because they know Tim Geithner can’t use his only real weapon.

Second, the incentives of managers and shareholders are not aligned. A major factor in the banks’ reluctance to participate in their own rescue seems to be fear of government interference, which is code for executive compensation restrictions.

Executives worry that whatever assurances the White House gives them, an angry Congress might impose new rules on banks that participate, particularly on pay. . . . “We’re certainly not going to borrow from the federal government, because we’ve learned our lesson about that,” [Jamie Dimon] said earlier this month in a conference about earnings.

Now, while I think some of the compensation caps discussed in Congress (but not passed by the Senate, as far as I know) were silly, I haven’t heard a lot of shareholders complaining about them; it’s the managers who don’t want them. So the situation is very simple. Participating in PPIP, for example, might be a net positive for shareholders, because even though it forces short-term writedowns, it also reduces the risk of larger writedowns in the future. But if managers think that it will lead to compensation limits, then it is a net negative for managers. I think our readers can fill in the rest of this thought.

61 responses to “The Importance of Battlefield Nuclear Weapons”

Two questions: first, you say that Geitner won’t use his only real weapon – letting the banks go bankrupt or pull their license. Why not? The shareholders are pretty much wiped out already and FDIC is there for depositors. Second, can’t an angry Congress impose new rules on banks regardless of whether they participate in government programs or not?

(Our resident banking industry shill calls me “penny wise, pound foolish”. I prefer to think of it as “millions for defense, not a penny for tribute”.)

Or, as Stiglitz and Ackman suggested on Charlie Rose last weekend, start forcing debt-for-equity swaps. That works too. It might require new laws or some Henry “Godfather” Paulson style tactics, though.

This is actually a really good point. If you can mark your “assets” wherever you like and take them to the Fed for near-zero-interest loans — and the regulators all look the other way — then you can never be insolvent in a cash flow sense.

As near as I can tell, this is the Plan. Cannot wait to see how it works out.

In short, companies are totally out of control because shareholders have abdicated their traditional role. Blame the system if you want, but such companies deserve to fail, the shareholders and bondholders probably deserve their losses, and the management certainly deserves to be fired. Capitalism only works if ownership confers responsibility.

2. I suppose they could, but it’s much more difficult politically. Most of the executive compensation rhetoric would begin with the phrase, “these banks that are taking taxpayer money . . .” Without that preamble it starts looking more like one-way government interference.

As long as we continue to approach banks with an adversarial mindset, we’ll not come up with the most optimal solution to turn around this recession. Just look at Bush’s foreign policy if you need proof.

We need to take a different approach.

US banks are hording 800 billion in cash instead of lending. There are 3 possibilities for why they do this.

1. There is a lack of qualify borrowers
2. The banks fear bank run
3. The banks fear getting nationalized because they are perceived as under capitalized

(Let me know if I missed any.)

If #1 is true, there is nothing to be done with the banks. The government has to stimulate demand and lower borrowing cost and the market has to adjust the price of goods and investments. If this is true, there is no immediate urgency to fix the banks.

#2 is very unlikely to be an issue today. The US government guarantees bank borrowing. Furthermore, we now have much clearer idea which banks are healthy (most are health enough). Banks across the board are enjoying very high earning. Look at the LIBOR graph.

#3 is most likely a real problem. Today, we’ve tightened capital requirements for banks. Long established capitalization measurements such as Tier 1 and TCE aren’t enough. Furthermore, there is huge populist anger over bank bailouts. Is it surprising that banks don’t want to end up like WaMu or Wachovia? Under the current circumstance, the strongest defense for a bank’s survival is to horde cash.

What we have here is opposite of zombie banks “gambling on redemption”. Most banks are healthy enough and choose to horde cash to defend its survival. Tightening capital requirement, talks of nationalization and populist anger over bailouts are all making the current situation worse. They all have pro-cyclical affects that magnify the current crisis.

We need to take a different approach.

We should tell the banks out right that because we are in a recession, we’ll temporary REDUCE bank capital requirements. The banks will not be threatened with shutdown as long as they can meet the lowered capital requirements. Furthermore, we should encourage the banks to earn their way out of their problem. Today, banks can earn around 3-4% interest spread and they have *800 billion* in cash not earning that spread! If a bank’s own survival isn’t being threatened, it has a huge incentive to make loans. Reducing bank capital requirement will be good for the economy, good for the banks and the least costly to the taxpayers. In a few years, after things quiet down, we can dial the capital requirement up again.

One objection may be what if a bank’s trouble keeps on getting bigger until it goes under? Look, taxpayers are already on the hook, directly or indirectly, for the trouble the banks are in right now. Rather we keep wagging our fingers at the trouble banks or not will not reduce that cost. A bank chooses not to lend because of survival fears will actually increase the overall cost to society.

What will reduce that cost is to help the trouble banks earn their way out. Also, remember the banks have already stopped the risky practice that got them in trouble. They are not making subprime loans. In deed, because there is so much scrutiny now, the loans for the next year or two will probably be the highest quality ever.

In summary, we should raise bank capital requirements during boom time and lower bank capital requirement during bust.

Until the banksters get exposed for who they are and what they’ve done (yes, I’m thinking Pecora II) they’ll resist any change that could threaten their status of Masters of the Universe.

A detailed public expose well covered by the media would force that change. That or the pitchforks; couldn’t happen to a nicer bunch.

Now, of course, it is obvious such a scenario won’t happen sui generis, if at all. After all, with our morally corrupt political class that can’t even agree that torture is a criminal act, what can be expected from people who receive so much campaign money from banksters, in exchange for having their set and spine surgically removed?

As long as this is the core administration religious tenet: “it really, genuinely wants to help them[the big banks and the big banksters personally]”, they’re pretty much self-hamstrung in what weapons are available.

If you dogmatically declare that something is Too Big To Fail and commit yourself emotionally to ensuring that it not in fact fail, you’ve artificially and unilaterally constructed something worse than the old Mutually Assured Destruction balance of terror, since in this case you’ve preemptively surrendered to “nuclear” blackmail and given the antagonist a blank check to demand, extort, obstruct, sulk and whine, throw tantrums, spit in your face, and in general be extravagantly predatory and loutish about it at the same time.

So long as we have this “leadership”, it’s going to be the same thing – the full responsibilities,costs, and exposure of “ownership” without any of the power or upside, which remain 100% with the gangsters, while they continue to obstruct and extort for every last penny’s worth at each and every point of each and every issue.

Why wouldn’t they? It’s what they are, it’s what they do, it’s what they will continue to do for as long as they exist, and as James’ post said, the Obama administration is absolutely committed to the continued existence and aggrandizement of this criminal class. All economic, and from there social and political, policy from here on ramifies out from this core priority.

To say that managers aren’t working in the interests of their shareholders seems a bit premature. That principle-agent problem has always existed, and I’m not saying that more shouldn’t be done about it. But the point made above is quite salient – further government intervention is just another step down the road to nationalization, which means that shareholder value is written down to zero. If banks are able to turn a profit in the first quarter (whether its from marketing making in the bond market, or from simple borrowing at 0% and lending at 5%), then maybe they think they can “churn” their way out of their capitalization problems. If total US writedowns are $275-$500 billion over the course of this recession, they are surely all not going to come at once. We must remember that a bank’s balance sheet isn’t a static thing, every day there are retained earnings that are shoved into the capital base. It is not surprising that those banks with healthy profits from market making (JP and GS), are the ones who are most itching to pay back capital…they probably think that they can earn enough over the course of this recession to compensate for future writedowns.

The point about shareholders not making a fuss about government intervention is also weak. Rarely have shareholders ever made a fuss about anything…and thats one of the bigger problems with our capitalist system. They never made a fuss when >50% of profits were being spent on bonuses rather than retained earnings or dividends. I think you’ll find that the only remaining shareholders that are left in BoA or Citi are those that are holding the shares as lottery tickets…not as an investment worth becoming actively involved in.

I am beginning to think that the government’s apparent softness on the banks makes some sense if (and it’s a big if) it is premised on an assessment that the banks are insolvent, the shareholders’ stake is illusory, and that the government already owns the problem. Why trash your own problem asset? If that’s the case, we are in a transition period, and the coddling of bank managements is a temporary measure that will keep those guys around only as long as necessary to develop a better approach to resolution.

Unfortunately, I’m not sure that I accept my own premise, in the sense that I’m not sure that the situation has clarified to the point that one can say with assurance that the interests of the financial institutions and their managers have been so completely vanquished that the only remaining issue is how to deal with the mess they created. I think a neo-Marxist analysis focusing on the conflict between the interests of a financial elite and a political class may be more productive. But, if that’s the case, I believe that the better analogy is to liquidating enemies of the people than to battlefield nuclear weapons.

the excess reserves that the banks are sitting on are not equity capital and so really have nothing to do with perceptions of whether a bank is capitalized or not. the excess reserves are mostly cash deposits and so they are both cash assets and senior liabilities.

that completely rules out #3.

#2 is a real problem. banks fear that they will be shut down because of bank runs. example: WAMU. there is no guarantee.

i will add #4: if bank assets have collateral triggers that depend on the bank’s rating (CDSs often do) then banks may need to hoard cash in anticipation of rating downgrades.

Why would Geithner be calling for resolution authority of non-bank financials if he is, in a post-modern sense, an agent of the banking oligarchs? Resolution authority is serious regulation. Furthermore, why would he call for registration of CDSs (all of them) when proponents of unfettered banking, Robert Rubin, Larry Summers and Allen Greenspan, defended unregulated use of these instruments on grounds that such use spreads risk evenly? [Ironically, they were not wrong!] Finally, why would Geithner not, at some time, have “crossed the street” to work for GS in order to reap the huge bonuses and rewards that really define banking oligarchs?

Facts are facts. Geithner is who he says he is, a straight-on, career, public servant and not a double agent of the “bankster” who is posing as Secretary of Treasury to cover his oligarchic colors.

In your “emerging markets” analogy and your indictment of the management of the current crisis you refer to Jaques Derrida and Michelle Foucault, two high-value iconoclasts. Hmm…and you call yourself a “centrist technocrat”? James, I see that pitchfork in your hand. Anyway, it was a thought provoking post and if it doesn’t quite fit in Geithner’s case, it explains much about the culture of Wall Street and America’s complaisance toward it.

the problem is “ownership” is, in the case of publicly traded firms, sufficiently dilute (and where not, sufficiently in the hands of the upper and middle managers) that it is incapable of making good long term decisions. I know this is heretical here, but maybe the publicly traded corporation is not the best model for a deposit institution. Maybe we would all be better off with 1000 medium sized credit unions instead of 3 “banks” TOO BIG TO FAIL.

If the stress tests reveal that one or more of the banks are technically insolvent, and one or more of those banks turn down additional capital because of the strings attached, and the reason they think they can get away with this is that the Obama administration wouldn’t dare touch their precious banking licenses, then I should think the answer is obvious: obey the law. Pick one of the weakest banks and shoot it in the face: liquidation, with the FDIC picking one (or more, preferably) of the smaller, more solvent banks to inherit that executed bank’s accounts. And announce that another one will be executed the next Friday if it doesn’t meet its capital requirements. That should clarify the thinking of the remainder adequately. And it has the advantage of being not merely legal already, without any changes from Congress, but (if I understand banking law at all after spending 6.5 years in the industry) actually legally mandatory.

James – thanks for the blog post above. Still I wonder – how does propping up failed institutions over the long term help the economy – and American industry overall – recover from the crash of ’08?

Please correct me if I am wrong – my takeaway from Henry Paulson’s initial description of the crisis last fall was that the toxic assets accumulated by these companies would take down the US economy if the government didn’t step in immediately with trillions of dollars to save the system.

A catastrophic situation, as he described it.

Was he lying? Are those toxic assets that we’re supposed to buy at a loss really a great deal? These banks weren’t at the brink of collapse? If not, was the system really frozen up just over rumors and innuendo that had no basis in reality?

If indeed Paulson was right, and the financial system of America was on the brink of total collapse, are taxpayers the only ones on the hook for those massively catastrophic business decisions made by extraordinarily compensated business leaders?

The system broke last fall. Developing a regulatory framework to ensure that we would never again see such a catastrophic breakdown of the system is absolutely essential for the survival of our economy – and our country.

“destroying Chrysler … and taking hundreds of thousands of jobs with it” – this overstates the size of the problem. Chrysler has only 26,000 hourly workers. As for spillover effect on jobs at the suppliers, there would be dislocation but the demand will be redistributed among the other OEMS and the jobs at suppliers would follow.

The country is at a crossroads to a great extent because of this taking care of themselves that banks do so well. The Obama administration’s desire to handle the banks with velvet gloves creates a false (I hope its false) sense of leverage for the banks. Coupled with their sense of entitlement and burgeoning self importance you get the audacious and insolent institutions that need help, but want no strictures whatsoever. For the country’s sake, I expect that velvet glove belies an iron fist. True if the administration had dealt with the troubled banks in the accepted manner prescribed, completely ignoring “too big to fail”, we’d not be having this conversation.

I disagree that bankruptcy is the only option on the table. The President has the bully-pulpit and can bring public sentiment into the equation; a necessity to get congress to do the right thing anyway. Even now some members of congress continue to heed the cry of Wall Street, working to water down bankruptcy and credit protections for consumers. If President Obama put public outrage on the table the banks would have a real problem. After all, nothing is more sad than congress covering its backside and the banks would be forced to eat some things that would be the result of congress going to far. Fairness towards banks is not unacceptable. Sadly, fairness requires honesty and a sincere desire to do the RIGHT thing, of which neither appears to have an address on Wall Street.

One thing that I learned as a Field Artillery officer is that you might only get to fire one nuke round – ever. Whether you are manning the delivery device or spotting the round, you might be within the blast area and subject to its effects – blast, radiation, EMP, etc. I really don’t think the political animals have the courage to fire the round when it probably means their own (political) demise…

“destroying Chrysler … and taking hundreds of thousands of jobs with it” – this overstates the size of the problem. Chrysler has only 26,000 hourly workers. As for spillover effect on jobs at the suppliers, there would be dislocation but the demand will be redistributed among the other OEMS and the jobs at suppliers would follow.”

Toyota itself does not believe what you said. Also, Chrysler has 10,000 skilled and managerial workers, too. And last I heard, over 1,600 dealers who also have employees.

Oh, and Chrysler was the company that produced tanks and such for the government in vaster quantities than predicted, at a fraction of the price expected, with better quality, and at no profit. But that was then, right? What have they done for me tomorrow?

Among several reasons why the bank managers don’t want to participate in PPIP is a big one: the Obama Administration has poisoned the well of the public trust. It’s aims are not trustworthy. Besides, the executive compensation issue, there is the issue of corporate governance. Obama fired the CEO of GM without any legal authority and ordered GM to change the production mix of its models. Why would any corporate executive trust Obama after that?

Then there is this about the Chrysler bankruptcy from Cianfrocca at Redstate:

“The public question relates to Fiat. Marchionne has been very emphatic that he will put no cash into Chrysler in return for Fiat’s stake, which starts at 20% and could go as high as 51% by 2016. Fiat is giving nothing but access to small-car technology. That can only mean that the government intends to dictate Chrysler’s production mix. That in turn means that the government has chosen to enter the auto business in a forthright and unprecedented way. ”

We’re now talking long term meddling and intervention into the private sector economy by our government. What manager or shareholder wants to be involved with that?

It’s true that Wall Street has captured far too much influence over regulators, but also when you think of it, the Government captured too much influence over Wall Street, starting with both Clinton Administration and the Boston Fed’s forcing of massive amounts of subprime loans on the banks.

James,
Thank you for your post.
1. You mention the ripple effect of a bank bankruptcy: “No more Lehmans”. It would seem that a controlled bankruptcy, more an FDIC receivership, would be very different from the chaotic collapse of Lehman. The ripple effect of Lehman had a lot to do with how utterly unexpected it was which freaked the markets and every single person out. We’ve had a long time to digest the fact that our largest banks are insolvent. Avoiding bank bankruptcies can’t be to protect depositors, that’s what the FDIC is for, or shareholders who have already lost out. Could it be to protect bank bondholders or any CDS loss on big bank bonds? If not, I can’t see a real reason not to just go ahead with structured bankruptcy.
2. If an angry Congress can impose new rules on banks regardless of whether they participate in government programs or not and even if that rhetoric began with “these banks that are taking taxpayer money . . .” – is that a bad thing? Isn’t Congress’s responsibility to protect taxpayers and the taxes they pay? “Without that preamble it starts looking more like one-way government interference.” Government interference isn’t always a four-letter word. We need government interference for Ponzi schemes, mail fraud, and I would argue reckless securities.

I’m not sure I would equate the effects of a structured bankruptcy for any one bank or even a few damanged banks with the devestating effects of a nuclear weapon. This is the exact kind of thinking that Wall Street is trying to perpetuate and that Paulson was peddling. And equating basically all the bigger banks as too important/big to fail in my opinion just magnifies the destructiveness of this assumption. When Lehman went down, LIBOR shot through the roof since everyone was worried about counterparty risk and lending effectively ceased. Maybe if the govt guaranteed inter-bank lending for a period of time during which it took Citi into receivership, the markets would have been better to absorb the shock. I have to believe those guarantees would have cost the taxpayer less than what we’ve put into Citi thus far. And yes, equity holders and junior creditors would have been wiped out, but then again, Citi stock and sub-ordinated debt were never supposed to be act like T-bills.

The gummint called the banksters bluff. Buh-bye hedge fund scum and other obstructionists. It’s ‘Morning in America!’

An excellent post and looks like the President and his posse mean business. I would submit there is a slightly different outlook on Wall Street today. It would seem that what the President said to the Republican Party he can now say to the Wall Street terrorists.

Well, actually, nothing much happened on Wall Street today…even after the Chrysler news, as it has been long factored in that Chrysler, as well as GM must go bankrupt. The market closed down less than 20 points.

If one of the big banks goes bankrupt, the bondholders take the hit. Or rather, assuming they hedged their exposure, the seller of the CDS takes the hit. All roads may not lead to AIG, but an awful lot of them do, and in all likelihood, a major bank failure would mean a fatal blow to AIG.

But AIG cannot be allowed to go bankrupt.

This is because, while FDIC backstops the bank deposits, and since September, Treasury has backstopped the money market funds, there remains one place where a “run on the bank” can still occur: life insurance. And AIG has $1.9 trillion in life insurance outstanding. Not only would an AIG bankruptcy be very bad news for widows and orphans, the risk of contagion is great.

Mr. Geithner has no authority to resolve non-bank financial institutions. He submitted legislation in February to accomplish this, and Speaker Pelosi promised expedited action, but last week Mr. Frank told the WSJ that this would have to wait till later in the year. It was “too complicated”, he said. Sen. Durbin might offer a pithier explanation.

As long as AIG is unresolved, AIG’s creditors will hold all the cards.

I believe this suggestion will work. If the banks refuse to play ball, pick the worst one and take it down. There are ample tools in place, and if this strategy is executed deliberately and while the govt. is in control of the situation, it will not incite a panic. Remember that as the crisis passes, the banks may become more arrogant again, but the government is no longer as dependent upon them to hold up public confidence.

The Stress Test, interestingly, laid the legal and public relations groundwork for taking this path. By declaring that 6 out of 19 banks were shown (after exhaustive review) to be:

a) large enough to put the system at threat
b) vulnerable to a serious financial shock

the govt. has the right to insist those banks seek additional capital. It also has the right to publicly identify one bank as the “most critical”, and give it a timeline. This very act alone – marking a bank as prey – will have a dramatic impact on the bank’s ability to function even if the govt. does not pull its license. (Why do business with a marked bank when there are 18 others that are perfectly fine? That bank’s stock price will subsequently reflect the lack of confidence in that institution.)

The is approach also should enable Treasury to set higher capital ratios for larger banks than smaller banks: any bank which is sufficiently large that its failure threatens the integrity of the system must meet higher capitalization standards (and, perhaps, lending standards). This will effectively increase the cost of capital for large banks (as compared to smaller banks), and create a competitive disadvantage for big banks.

I do not think the problem is that Treasury and the Fed and FDIC lack weapons… I think the problem is that the banks perceive Geithner as weak and easily pushed around. The little kid who always gets bullied, but wants so badly to be part of the in-crowd that he keeps coming back for more.

This is a Teddy Roosevelt moment. It’s time for administration to show the banks who is really boss. The public craves the theatre – it would be a masterful political stroke.

I truly hope Geithner proves us all wrong and shows the bullies the door. If he pulls this off, Obama can claim two victories – one for standing up to the banks, and one for standing by someone who (in the end) proved himself worthy of that confidence.

Absolutely right. Tighter FASB requirements would have been the “battlefield” nukes James cites, putting a steady public need to raise capital on the banks.

Going the other direction – as we did – backs the government into a corner. Since banks can now report their balance sheets however they wish, a bank such as WFC that basically refuses to recognize losses can show fantastic earnings and a high capital ratio. If the government were then to step in, WFC would jump up and down insisting “we are doing fine, we are making $3bn a quarter and have $45bn imaginary dollars of equity, how dare you communists come here”.

Just Bulow Plan them. Once the managers find out that the great money is to be made running the Bad Bank side (with incredibly thin equity and no restrictions on business practices, it’s a public hedge fund with a permanent lockup), folks will come around willingly.

Thanks James Kwak
I was looking for just such a discussion, but I had the naive hope that there were more tools than the stick, the carrot & the nuke.

re Chrysler, even bankruptcy & public shame won’t stop the brinkmanship– the bondholders continue their efforts to put on the squeeze…
“The issue is less whether they’ll win than whether they can cause a meaningful delay that may cause Chrysler or the government to come to an accommodation.”
from: Obama Says Chrysler Holdout Lenders Speculated on U.S. Bailouthttp://www.bloomberg.com/apps/news?pid=20601103&sid=anOtOhu3yDyU&refer=news

Wow… Obama wasn’t messing around when he called them speculators:
“What is striking to many in financial circles is how much Chrysler’s reluctant creditors gambled for what is, in the scheme of this bankruptcy, a relatively small amount of money.”
…
“The other creditors, who sought to distinguish themselves from those who have received bailout money, believed they had a stronger hand. Many of them bought Chrysler debt for about 30 cents on the dollar, long after it became clear that the company was in trouble. Most of this debt is secured by Chrysler assets — factories, equipment, real estate and the like. The thinking was that in the worst case, these assets could be sold at a profit if Chrysler were liquidated.”

Banks are definitely lending as you point out. However, banks are also sitting on a huge pile of cash. In other words, they could be lending more if they weren’t held back. I am trying to understand what could holding the banks back.

I suspect #4 is not the issue because banks are net buyers of CDS. This makes sense since banks own a lot of mortgage back securities. The collateral triggers applied to CDS sellers like AIG.

#2 vs. #3

To start, we don’t know that all 800 billion in cash the banks are sitting on are not equity capital right? I’d agree with you if we know with certainty that the banks are insolvent today. I know this is a religious view for baseline scenario. On the other hand, the market place definitely has a lot of doubts. I think portions of the cash the banks are sitting on are equity. If you look at tangible common equity (TCE), all the major banks are at an all time high (similarly for Tier 1).

Why banks fear bank runs (liquidity) isn’t an issue?

Here is why I don’t think #2 “banks fear bank runs” is an issue. Banks fearing bank run is a liquidity problem. Even healthy banks fear bank runs. Liquidity problem was a major problem after Lehman failed last September. You can see from LIBOR that after Lehman, banks charged very interest rates lending to each other. At the time, no one knows which bank will fail next. Part of the reason WaMu (after Lehman) went under was a liquidity problem. Here is good analysis of what happen to WaMu.

The Fed, FDIC and Treasury have an alphabet soup of programs all designed to increase liquidity for banks. Furthermore, the US saving rate went from below 1% to over 4%. Much of the savings went into bank deposits. At any rate, the evidence that liquidity isn’t an issue today is overwhelming.

What do banks have to fear?

A bank can continue to satisfy its creditors as long as it has enough cash on hand (e.g. keep up to date with regular repayments). Since liquidity isn’t an issue for the banks, the banks only have to fear the government. The government came up with banking regulatory requirements so that trouble banks don’t end up spending every last dime and leave the tax payers to mop up. The government wants to come in and clean up a trouble bank when there is still some value left (i.e. minimize bank failure cost).

Banks are not lending because they want the economy to collapse, they then can use the money lent to them by the Fed to buy up businesses on the cheap. It is the classic boom & bust banker take-over. History is repeating itself because our Federal congress has removed the last depression era banker safe guard, namely (Glass-Steagall) Banking Act of 1933. This legislation forbids banks from creating and trading in securities. How was this safe guard removed? It was removed in the “Gramm-Leach-Bliley” Act of 1999. Many of the congressmen who voted this bill into law are still in our government. This bill was the chief device that destroyed the world economy. I encourage you to visit govtrack.com and find out if your representative was part of this bill.